Can All the Exchange Rates Fall?

All of the world's major currencies are set to fall. That is the inference from the forecasts of currency strategists.

The US dollar is set to tumble because multi trillion dollar government deficits will test the patience of overseas investors. They will not keep funding US excess and, as they repatriate their funds (or refuse to subscribe new money), the dollar will collapse.

Meanwhile, a lengthy global recession will sap the strength of export dependent European economies. Structural shortcomings will also limit growth potential. Their interest rates will continue to fall as the European central bank belatedly recognizes that fighting inflation is not that important after all. Some are also toying with industry protection policies, making an even less attractive mix.

The yen will continue to suffer from falling Japanese exports and an inevitable emphasis on domestic production among its traditional customers as recovery commences. Income from Japan's overseas investments will falter as long as the major developed economies are in recession.

China's yuan will also depend on growth in exports and the country's capacity to keep savings high. A more consumer oriented economy was going to put some pressure on that outcome under any circumstances but now the Chinese government will be encouraging a cut in savings as its income potential sags from poorly performing export markets.

Among the lesser currencies, Australia's dollar must contend with commodity prices in a cyclical trough. The government is seeking to stimulate domestic demand as export income declines but the currency has already slumped dramatically and, even if it falls no further, the consensus is for little or no recovery.

But currencies are relative prices. They cannot all fall in nominal terms simultaneously.

Despite pessimistic commentaries about the likely trajectory of the US dollar, it has risen by 17% against the major non-dollar currencies since March 2008, the fastest rate of increase since early 1985.

The US dollar has a history of appreciating during recession. The chart at http://www.thebigpicture.com.au/atc/ustwex.htm shows the US dollar trade weighted exchange rate against the major currencies. Periods of US recession have been highlighted. The currency rose between 4% and 18% in each of the recessions of 1974, 1980, 1981 and 2001. The recession of 1990 was the only post-1970 recession during which the US dollar declined from the outset.

So, a weakening US economy does not translate into a flight from US dollar financial assets. In fact, "Global recession? Buy US dollars!" might be the best advice in the face of a weakening US (and global) economy.

The US dollar's strength comes from its unique position among the world's currencies. Despite all the readily identifiable faults of the US economy, it has been consistently better able to cope with hard times than any other. There is a long history of US innovation and business dynamism sustaining the largest economy in the world and creating the freest and most innovative capital markets.

The chart also shows a long-term downtrend in the US dollar of 27% over 36 years. There have been periods of strong appreciation from time to time but the peak values have been declining and the trough values getting lower.

An irony of market economics is that the US dollar will probably start to fall, as it has done before, when evidence starts to show that the recession is easing. That might be some time in coming but, once the US economy can show the beginning of a recovery, the need for a global financial safe harbor will have been reduced. Investors will be more prepared to take on risk. They will be more prepared to buy yen, sterling and Australian dollar denominated assets.

Perhaps the commentaries are right and all of the currencies will fall but not at the same time.

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